Why do Banks Exist?

Banks play an important role in the economy as financial intermediaries, matching
up lenders and borrowers.

Lenders direct a portion of their financial wealth to bank deposits. Borrowers seek
loans to finance assorted expenditures, including investment in the mining activity.
 Banks act as intermediaries, issuing debt and equity to capitalize their
intermediation activities.
 Relative to direct lending banks issue safe, demandable deposits, thus removing
the need for savers to monitor the risk-taking behavior of the borrowers.

Bank intermediation allows lenders to have timely access to their savings while
also giving borrowers the option to borrow for longer period investment plans.
Banks’ Three Transformation Activities
Banks, as Financial intermediaries, are agents that
undertake three critical transformation activities:
I.
Maturity Transformation
II. Liquidity Transformation
III. Credit Transformation.
A Stylized Bank Balance Sheet
•
•
•
•
•
Consumer Loans
Business Loans
Investment securities
Reserves
Physical assets
• Cash and other liquid
assets
Bank Assets = Bank Liabilities + Bank Capital
• Deposits
• Bonds
• Repos
Capital
• Shareholders Equity
Maturity Transformation
 Banks use short-term deposits to
fund longer-term loans.
 Traditional deposits are a bank’s
liabilities, collected in the form of
savings and checking accounts and
redistributed as loans to
consumers and businesses.
 Because short-term deposits are a
bank’s liabilities and long-term
loans are its assets, there is an
inherent risk in maturity
transformation.
Long-term
Short-term
Maturity Transformation & Interest Rate Risk
 Because the maturity of the loans
is longer than that of the liabilities,
a bank assumes interest rate risk.
 When interest rates increase, the
value of a bank’s assets declines
more than the value of its
liabilities, assuming all else holds
equal.

Interest rate risk was once a
significant concern, but interest
rate hedges now commonly reduce
its effects.
Interest
Rate
Liquidity Transformation
 This allows the banking system to create money. Note that there is no
reserve requirement in the UK, or Canada.
 If all depositors simultaneously withdraw their funds
a bank will be forced
to sell assets to meet depositor demand.

Such mass exits at fire-sale prices can cause bank insolvency as the value of
assets declines below the value of liabilities.
Liquidity Transformation
 Closely related to maturity
transformation, liquidity
transformation refers to the fact that a
bank’s assets are less liquid than its
liabilities.
 Depositors 'money (the liabilities that
fund the assets) is available on
demand at any time, while the loans
(a bank’s assets) have a longer, often
fixed life.
 Most banks worldwide
hold only a
fraction of bank deposits as cash on
hand, available for withdrawal.
Liquidity Transformation and Creation of Money
 Liquidity Transformation
allows the
banking system to create money.
 If all depositors simultaneously
withdraw their funds a bank will be
forced to sell assets to meet depositor
demand.

Such mass exits at fire-sale prices can
cause bank insolvency as the value of
assets declines below the value of
liabilities.
 Note that there is no reserve
requirement in the UK, or Canada.
I.
How money is being created?
Credit Intermediation
•
In simple terms, credit intermediation
is a bank’s attempt to generate returns
through credit mismatches between
assets and liabilities.
•
It is typically conducted by investing in
securities that have a lower credit
standing and thus a higher yield than
the bank’s funding instruments.
•
A bank can take advantage of
arbitrage opportunities and
irregularities in the market through
credit transformation transactions.
AA
AAA
For example, bank may carry out credit
transformation by lending to AA borrowers while
issuing AAA liabilities.
Credit Transformation
 While any individual loan carries
risk specific to that transaction, a
bank diffuses its overall risk
exposure by lending to a large
number of borrowers.
 Despite this diversification, the
riskiness of a bank’s assets usually
exceeds that of its liabilities.
 Taking on this credit risk is typically
how banks earn a return above the
cost of their liabilities, a concept
known as net interest margin.
Asset
Risk
>
Liabilities
Risk
Credit Risk

Credit risk is defined as the risk that a counterparty will fail to perform fully its
financial obligations, and can arise from multiple activities across sectors.
 For example, credit risk could arise from the risk of default on a loan or bond
obligation by a mining company, or from the risk of a guarantor, credit
enhancement provider or derivative counterparty failing to meet its obligations.
 The goal of credit risk management is to maximise a bank's risk-adjusted rate of
return by maintaining credit risk exposure within acceptable parameters.
 Banks need to manage the credit risk inherent in the entire portfolio as well as the
risk in individual credits or transactions.
 Banks also consider the relationships between credit risk and other risks.